Effective Venture Capital Contracts Come in Many FormsResearch by Steven N. Kaplan and Per Strömberg
How much can venture capitalists protect themselves against
losses if an investment goes bad? How much control should entrepreneurs
be prepared to give up? What happens to both parties when a
new venture succeeds? To successfully tackle the good, bad,
and in-between stages of new ventures, writing the appropriate
financial contract is key.

From 1996 to 1999, venture capitalists (VCs) became well-known
players beyond the business community, as more and more people
learned who exactly gave the dot-coms their start-up money.
VCs and entrepreneurs unite based on a promising idea and a
solid business plan. If VCs decide to invest, they will give
the entrepreneur a term sheet listing conditions for investment.
This begins a set of negotiations to hammer out a contract,
a process that can take anywhere from a few days to a year.

A wide array of economic theories on venture capital has been
developed in recent years, the majority taking conflicting positions
about which aspects of financial contracts are most important
and what types of contracts are possible. In "Financial
Contracting Theory Meets the Real World: An Empirical Analysis
of Venture Capital Contracts," two University of Chicago
Graduate School of Business professors, Steven N. Kaplan and
Per Strömberg, take a comprehensive approach to studying
venture capital contracts, rather than relying upon market folklore
and anecdotal evidence as some have done in the past. Using
a broad sample of venture capital contracts, they find that
real-world contracts are far more complex than existing theories
predicted, with a surprising degree of variation from one contract
to the next.

Kaplan and Strömberg find that venture capital financings
allow VCs to separately allocate cash flow rights, board rights,
voting rights, liquidation rights, and other control rights,
often contingent on measures of performance. In general, board
rights, voting rights, and liquidation rights are allocated
so that the VCs obtain full control if the company performs
poorly. As company performance improves, the entrepreneur obtains
more control rights. If the company performs very well, the
VCs give up most of their control and liquidation rights and
retain only their cash flow rights.

"Entrepreneurs have to understand that while many contracts
look very harsh, and it may seem like the VCs have too much
control, that's really not the case," says Kaplan. "If
you don't write the contracts a certain way, the VCs won't give
you any money, and some entrepreneurs have trouble understanding
this."

For new entrepreneurs, it is important to grasp the finer points
of venture capital contracts, and in particular the rights of
VCs. As the authors have found in follow-up conversations with
the VCs in the study, even seasoned VCs can benefit from knowing
how other VCs are structuring their contracts. By bringing attention
to the intricacies of venture capital contracts, the study opens
the door to more informed negotiations and better decision making.

The Rights

"Underlying all the negotiations is the desire for everyone
to get the required rate of return for the money they are putting
in," says Strömberg. "You also need to align
incentives to make sure everyone is working toward the same
goals, and to allocate control so that things can be changed
if goals are not met."

Kaplan and Strömberg based their study on a sample of
213 investments in 119 companies by 14 venture capital firms.
Each firm provided the contractual agreements governing each
financing round in which the firm participated. When available,
the venture capital firm also provided the company's business
plan, internal evaluations of the investment, and information
on subsequent performance.

"These contracts are tailored to different situations,
and there are a lot of levers that VCs can pull," says
Kaplan.

One of the first decisions in contract negotiations is the
type of security issued to the VCs. Separate securities are
used for VCs and entrepreneurs in order to give VCs different
rights. Rights regarding board control and liquidation, for
example, are tied to the VC's stock. Kaplan and Strömberg
find that convertible preferred stock is the most commonly used
security, used in 204 of the 213 financing rounds in the study.
The "convertible preferred" aspect of the stock allows
the VC to convert the stock into a common stock if the company
does well, and to use the stock like a bond if the company does
poorly. Even in cases when common stock is used, VCs get a different
class of common stock with different rights from those of the
founders.

Similarly, contracts allow for different cash flow rights for
venture capitalists and founders. "Cash flow rights determine
how the pie will be split between VCs and entrepreneurs once
the company goes public," says Strömberg, "and
the split is often contingent on performance measures."
In the sample contracts, the VC controls approximately 50 percent
of the cash flow rights on average, founders control 30 percent,
and others control 20 percent, indicating that founders give
up a large fraction of ownership.

Liquidation cash flow rights and redemption rights work together
to protect the VC's investment if the company is sold or performs
poorly. In nearly all cases, VCs have claims in liquidation
that are senior to the common stock claims of founders. In 98
percent of the cases, VC claims are at least as large as their
investment.

"Liquidation rights are not going to be very important
if the company fails, because there will be nothing left to
liquidate," says Strömberg. "These rights become
important when the company is simply performing okay, but not
great. Putting liquidation and redemption rights together means
that if nothing has happened in five years' time, for example,
the VC has the right to demand repayment. It's a way to get
money out of ventures that are only performing marginally."

Board and voting rights allow VCs to have input in decisions
about top management, corporate strategies, and any other action
not already specified in the original contract. In 18 percent
of the cases, provisions are made so that the VC will get full
control of the board if the company performs poorly. In first
venture capital rounds, 41 percent of the cases allow VCs to
have voting majority.

Building Incentives for Entrepreneurs

Kaplan and Strömberg find that venture capital financings
include a number of additional terms and conditions beyond the
basic rights. For example, venture capital financings often
include automatic conversion provisions in which the security
held by the VC automatically converts into common stock under
certain conditions. These conditions require that certain financial
targets be met, and almost exclusively depend on an initial
public offering that exceeds a designated common stock price.
If the company goes public for a high value, the VCs only keep
their cash flow rights, ceding the majority of control to the
entrepreneurs. At some point after VCs give up control, they
sell their stock and move on to new investments.

An automatic conversion provision is present in 95 percent
of the financing rounds. Financings that included this provision
also required that the stock price of the initial public offering
be on average three times greater than the stock price of the
financing round. The VCs are therefore not willing to give up
control unless they triple their money.

Many contracts also utilize vesting and noncompete clauses
to make it costly for the entrepreneur to leave the firm. Tying
the entrepreneur to the firm is particularly important in cases
where most of the value of the venture lies in the entrepreneur's
unique skills. Also, vesting clauses give the VCs a way to remove
a badly performing CEO without having to keep him or her as
a potentially obstructing minority investor down the road.

The vesting provision requires that the entrepreneur's shares
vest over time, and thus if the entrepreneur leaves before the
end of the vesting period, they will lose all of their stock.
This provision is used in approximately 41 percent of financing
rounds. The VCs also can require the entrepreneurs to sign a
noncompete contract that prohibits him or her from working for
another firm in the same industry for some period of time after
leaving. Noncompete clauses are used in approximately 70 percent
of the financings.

Of the many possible contingencies attached to different rights,
73 percent of the financings include at least one contingency.
In almost 15 percent of the financings, the VCs provide only
a portion of the total funding commitment at the signing of
the financing. Additional funding is contingent on subsequent
performance and actions. Along with financial performance, VCs
also may consider such indicators as product performance or
FDA or patent approvals. Kaplan and Strömberg's findings
contradict earlier theories, which argued that such performance-based
contingencies cannot be written into contracts because they
cannot be measured. VCs can and do write contracts with a variety
of contingencies, indicating managerial actions that the VC
is trying to induce or avoid.

Future Studies

This study is the first in a series of papers on the venture
capital investment process that Kaplan and Strömberg are
developing. A second paper examines the screening of investments,
looking at how VCs monitor and support their investments after
the contracts are written. They are currently researching venture
capital outside the United States. Until recently, venture capital
has been less prevalent and less successful outside the United
States, and their study examines why this is the case.

In regards to this initial study on financial contracts, Kaplan
notes, "There's a real public policy angle to it. If these
contracts are sensible in the United States, and other countries
want to know how they can get more VCs to invest, then these
are the things other countries should allow their laws to do."

Steven N. Kaplan is Neubauer Family Professor of Entrepreneurship
and Finance at the University of Chicago Graduate School of
Business. Per Strömberg is associate professor of finance
at the University of Chicago Graduate School of Business.